IMBA Financial Accounting
Instructor: Guohua Jiang (姜国华）
University of California, Berkeley (加州大学伯克利分校)
田长霖，陈省身，李远哲，赵元任，张爱玲, 钱颖一 。。。
Most recent Nobel Prize winners: Daniel McFadden (2000), George Ackerlof (2001)
What a “great” time for accounting?
Or isn’t it? Accounts: angels or devils? You may hate them, but you have to have them
2002, the year of accounting
Enron, Worldcom, George W. Bush, Dick Cheney
Blame accounting on anything, from investor losses to Saddam Hussein hiding nuclear weapon
But we stay cool!
Time Magazine: Persons of the Year 2002: Whistleblowers
Cynthia Copper of Worldcom
Colleen Rowley of FBI
Sherron Watkins of Enron
When you think of accountants, what image comes up to your mind?
The Father of Accounting-Luca Pacioli (1445-1517)
He wrote a famous mathematics book
In one chapter he invented double-entry accounting system
He taught Leonardo Da Vinci perspective and proportionality. The knowledge was used to paint “the Last Supper”
Dow Jones Industrial Average 1930-2002
DJIA, NASDAQ 1990-2002
Back to Square One: DJIA 1998-2002
or -NASDAQ 1998-2002
The Three Major Stock Exchanges
The Regulator of . Stock Market
SEC, the Securities and Exchange Commission
Arthur Levitt, commissioner, 1993-2000 in the Clinton administration
Numbers Game Speech, 1998
The current SEC commissioners
Who issue American Accounting Standards
FASB: Financial Accounting Standards Board
Set up in 1973 to replace Accounting Principle Board (APB)
An independent, private organization
Standards issued recognized by SEC
GAAP: Generally Accepted Accounting Standards
7 concept statements (principles)
., No. 7 (February 2000) Using cash flow information and present value in accounting measurements
148 statements of standards (rules)
., No. 1 (December 1973) Disclosure of foreign currency translation information
International Accounting Standards
International Accounting Standards Committee (IASC)
Based at London
Independent and privately funded
Meant to design a set of worldly accepted accounting standards
Mr. Shuping Feng from Chinese Accounting Standard Committee serve as an advisory board member
International Accounting Standards
41 standards up to date
., IAS 2. Inventory, January 1, 1995
“Big Four” International Accounting Firms
Ernst Young (worldwide revenue 2002: $ billions, billions in the .)
PriceWaterhouseCoopers
Deloitte & Touche
KPMG
Arthur Anderson (oops!)
Auditor Opinions
Unqualified
“Unqualified” opinion is actually good opinion, confused? I was.
Qualified
Disclaimer of opinion
Adverse opinion
General Electric 2001 Annual Report (10K)
The users of accounting and economic consequence of accounting decisions
Equity investors
Creditors
Government
Customer
Suppliers
Labor union
Investing Motto
Two friends went hunting in the jungle. All of a sudden, a bear jumped out of nowhere and came after them.
A: Run!
B: No, it is hopeless, we won’t overrun a bear.
A: But I do not have to run faster than the bear. I only need to run faster than you!
Financial Accounting and Tax Accounting
Tax accounting is designed by IRS, Internal Revenue Service
Major difference in revenue recognition and expense recognition
Tax accounting can embed government’s economic policies
Goals of this course
How to read financial statement
How to interpret financial statement
What inferences to draw from financial statement
How to base economic decisions on the information in financial statement
A language to communicate in business community
To make friends
Syllabus
A financial statement user’s perspective
Emphasize two issues: Earnings Management and valuation
Frequent mini-case analysis
One big case analysis, individually or in groups
News articles will be tested in final exam
Expect to read A LOT!
Earnings Management: Rao, Teoh, Wong, Review of Accounting Studies, 1998
Earnings restatements – Min Wu, HKUST
Accounting-based Valuation
Who are my peers? Earnings multiples, book-value multiples, sales multiples
EVA®, Economic value added, Residual income valuation (RIV), Edward, Bell, Ohlson Model (EBO)
In one word, Share value = f (earnings, book value, dividend, cash flow, etc.)
Accounting-based Valuation-2
Ultimately, we do valuation to earn higher returns on stock trading.
We get an intrinsic value number, compare it to prevailing stock price, if our value estimate is higher than price, we buy; otherwise we sell.
Frankel and Lee, Journal of Finance, 1999
To get papers mentioned, from a PKU computer, go to or just ask from me.
How important is accounting information?
January 22, 2003, after market closed, AT&T (stock symbol T) announced:
Revenue for 4th quarter shrank to $ billion from billion in the 4th quarter of previous year
Loss from continuing operations widened to $611 million from $216 million.
How important is accounting information?
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How important is accounting information?
In the weekend before Monday, Feb. 3, 2003, Mattel (MAT) announced fourth quarter results:
Revenue increased from the fourth quarter a year earlier by % to $ billion.
Net income increased by 35% to $ million.
Earnings per share (EPS) increased to 42 cents from 31 cents.
How important is accounting information?
()
Value Investing
Warren Buffett ()
Accounting concepts and principles
Entity concept
Reliability principle (objectivity principle)
Cost principle
Going-concern concept
Stable-of-monetary-unit concept
Conservatism principle
Accrual accounting concept
Entity concept
A company is an independent entity. Only transactions that are related to the company itself, not a particular person working for the company, should be considered company affair and be recorded.
Example: the owner of an ice cream store gives an ice cream to his niece; this act is not a business transaction, it is family affair. But if he gives to a neighbor’s niece, it is a business transaction. It is called promotion.
Reliability principle (objectivity principle)
Accounting numbers 1) should be verifiable, and 2) can be confirmed by an independent observer.
Examples of unreliable numbers:
Men’s weight
Women’s age
Number of years a . takes to finish his degree
CEO’s pay
Enron’s earnings
Historical Cost Principle
All acquired assets should be recorded at their actual cost, ., the amount of money paid to obtain the asset, even though the cost of the same asset today is different.
Why? Historical cost is reliable.
Going-concern concept
It is like people in the past who wish an emperor lives forever, we assume companies live forever, although they tend to die fast.
Why? Because if we assume going-out-of-business concept, many wired things will happen.
1) Assets need to be recorded at current market prices
2) Liabilities will have to be repaid right away
3) Earnings and book values do not matter
Going-out-of-business is the exception, not the rule.
Stable-of-monetary-unit concept
One dollar today = One dollar tomorrow
Why? Purchasing power changes due to inflation or deflation
But we are ok. If the change in price level is not too dramatic, we hold the stable-of-monetary-unit concept. Otherwise, every account will have to be adjusted every quarter.
Conservatism principle
The tension between creditors and shareholders and the tension between shareholders and management dictate that accounting is conservative.
Report bad news in financial statements as early and as complete as possible; report good news in financial statements only after the uncertainty surrounding the good news is resolved.
Conservatism principle - examples
Research and development expenditures
Advertising expenditure
Other promotion expenditures
Relationship buildup costs
All these expenditures will likely generate future benefits for the firm. But they are expensed, not capitalized as assets on balance sheet because their benefits are uncertain and hard to measure.
Accrual Accounting
Revenue: recognize whenever it is earned, not when cash changes hands
Expense: recognize whenever it is incurred, not when cash changes hands
Financial Statements
Balance Sheet: at a point in time, ., December 31, balance sheet measures how much asset the company own, how much debt the company owe, and how much equity shareholders have in the company
Assets = Liabilities + Equity
Income Statement: during the period ending on the balance sheet date, , during the year, how much revenues the company generates, how much expenses are used to generate the revenues, and the earnings (Revenues – Expenses). Profits increase equity on balance sheet, while losses decrease equity on balance sheet.
Statement of Retained Earnings: Beginning equity + Earnings – Dividends = Earnings equity (on balance sheet)
What accounts go where?
Balance Sheet accounts: 1) can and can only be measured at a point in time, 2) physically or quasi-physically exist, and 3) can be carried over and used next period
Income Statement accounts: 2) can and can only be measured in an interval of time, 2) does not physically exist, and 3) can not be carried over to next period
Financial Statements
Statement of Cash Flows
Cash is king.
Three sections: Operating, Investing, Financing
Operating: cash flows related to the normal operation of the firm
Investing: cash flows related to investment in assets that generate operating cash flow in the future
Financing: cash flows from and to shareholders and creditors
Financial Statement: Income Statement
For more about basic finance accounting, go to course website and read ‘A premier on accounting”
Prefer to be called Guohua, or Jiang Guohua. Jiang Lao Shi is not necessary
Guanghua grad. Photo of my dorm room at Bldg. 28.
Introduce HKUST and Berkeley. Often been asked “there is . in accounting?”
Anderson disappeared, but its employees are not unemployed.
In fact, SEC is hiring more accounts to catch accounts.
In fact, accounting professors get to give speeches or get interviews more often
1. Luca Pacioli (1445-1517)
Luca Bartolomeo Pacioli was born around 1445 at Borgo San Sepulcro in Tuscany. He was an accomplished mathematician who became a Franciscan friar in 1482. In 1494 Pacioli wrote his fifth book, Summa de Arithmetica, Geometria, Proportioni et Proportionalita (Everything About Arithmetic, Geometry and Proportion), a digest and guide to existing mathematical knowledge. Its 36 chapters on double-entry bookkeeping constituted one of five topics covered and were included, in part, to "give the trader without delay information as to his assets and liabilities."
The Summa's publication on November 10, 1494 made Pacioli instantly famous, becoming the most widely read mathematical work in Italy and one of the first books published on the Gutenberg press (named for the German printer Johann Gutenberg, the inventor of movable type). After the Summa's publication, Pacioli was invited to Milan to teach mathematics where one of his pupils was Leonardo da Vinci, to whom he taught perspective and proportionality. This knowledge allowed da Vinci to create one of his greatest masterpieces, and the most famous painting of the fifteenth century, a mural on the north wall of the Santa Maria de Gracia Dominican cloister known as "The Last Supper."
In 1514, Pope Leo III called Pacioli to the papacy in Rome to be a teacher. Scholars believe Pacioli never made it to Rome, dying on June 19, 1517 in the monastery in Sansepulcro. In the first century after its publication, the Summa was translated into five languages and numerous details of bookkeeping set forth by Pacioli were followed in texts and the profession for at least the next four centuries.
Earnings drive stock prices in the long run. This index testifies to the success of American businesses in the last century
How many stocks in this index? Also called blue chip stocks, they are large, and stable, and leaders in their respective industries
1. Why Bill Clinton got away from the Lewinsky scandal? It is the economy.
1. In this years, the dividend payout ratio of . corporations was very low. That means the wealth generated in 98, 99, 00 is gone. Some people made money from other people, but as a whole, the shareholders collectively did not better off.
1. What a ride?
As of Nov. 30, 2002. Exchange, # of listed companies, Market cap. Of US companies, In billions NYSE 2793 9400 AMEX 796 200 NASDAQ 3849 2200 US 23100 Source: , , and
1. As always, he is a Jewish.
1. Harvey Pitt, a lawyer representing the accounting industry. While Arthur Levitt targeted accounting industry for lack of independence and conflict of interest, George Bush picked the industry’s lawyer to be new SEC commissioner. When in 2002 US congress enacted an accounting oversight board at SEC, Pitt picked a past CIA director, William Webster, to be its chairman. Before Webster took office, it was revealed that he was a board member of a company being investigated by SEC. Pitt knew this information but did not share with other commissioners and congress when he tapped Webster.
1. Accounting standard setting process is very much a political process. Companies lobby congressmen or SEC to block FASB from issuing adverse standards.
Guess how we the EY revenue amount, devoice.
The equity stake of the nearly 1,900 partners fell to $422 million from $525 million a year earlier, a percent decline. Average cash earnings per partner were $565,000, up percent from $515,000 the year before.
Take a look at this article, even if you do not learn any accounting from it at least you learn what damage devoice can do to you.
Accounting and legal industries: guaranteed customers, self-fulfilling standard setting process
Who regulate accounting industry? No one. A self-regulatory body: AICPA
Speak English in class and in office hours. But do come to office hours.
Monday lunch
Class representative: collect feedbacks, organize Monday lunch
Enron readings on class website. Students are encourage to read.
Read textbook after lectures
Price effect
Trading volume effect
Could accounting-based research have helped? Yes, otherwise stock picking would have died a long time ago.
Financial Statement: Income Statement-Microsoft 1999
1. Why MS does not have long-term liabilities? Cash.
